The Closing Bell-4/29-30/11
Steve Cook on Disciplined Investing

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Statistical Summary

   Current Economic Forecast

    2010 (revised)

     Real Growth in Gross Domestic Product:        +2.5- +3.5%
     Inflation:                                                                      1-2 %
     Growth in Corporate Profits:                                   10-20%

   2011

    Real Growth in Gross Domestic Product:        +1.5- +2.5%
     Inflation:                                                                      2-3 %
     Growth in Corporate Profits:                                     7-12%


Current Market Forecast
   
   Dow Jones Industrial Average

      Current Trend (revised): 
         Short Term Up Trend                           12280-12935
         Intermediate Up Trend                         12017-15435
         Long Term Trading Range                      7148-14180
          Very LT Up Trend                                 4187-14789   
               
     2010    Year End Fair Value (revised)    10095-10115
 
     2011    Year End Fair Value                    10750-10770

  Standard & Poor’s 500

     Current Trend (revised):
        Short Term Up Trend                   1308-1395
        Intermediate Up Trend                 1263-1692   
        Long Term Trading Range           766-1575
       Very LT Up Trend                           644-2000

    2010    Year End Fair Value          1240-1260   

   2011    Year End Fair Value           1320-1340

Percentage Cash in Our Portfolios

    Dividend Growth Portfolio                  21%
    High Yield Portfolio                             21%
    Aggressive Growth Portfolio              22%

Economics
   
The economy is a modest positive for Your Money. 
This week’s economic data was neutral to slightly positive.  The housing numbers were mixed, the consumer and industrial stats were up beat while the first quarter GDP pointed to a lessening in the rate of economic growth.  In other words, they fit our forecast to a tee: (1) a below average secular rate of recovery resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with an impaired balance sheet and a business community unwilling to hire and invest because the aforementioned, (2) the likelihood a rising and potentially corrosive rate of inflation due to excessive money creation and the historic inability of the Fed to properly time the reversal of that monetary policy. 

Two other items also held investor attention this week:

(1)    the continuation of better than expected earnings reports.  As you know from our discussions this week, I don’t except the rather simple equation that better than estimated profits equals an economy improving at a faster rate than anticipated.  I have already gone through the arguments as to why; but in summary they are Angel profit margins are at historic highs, profit margins are mean reverting, therefore further profit increases depend on rising revenue which will be extraordinarily difficult to do domestically when the growth rate of GDP is slowing and Beer  while revenues are continuing to increase at an above average rate in many foreign markets, a large percentage of that growth is coming from foreign subsidiaries versus exports; those foreign earnings are not being repatriated due to US tax law and as a result are of little practical value to US stockholders in that they can’t be used for US investment or dividend payments.

(2)    the FOMC met and the Ber-nanke held the first press conference following a meeting in history.  However, we learned nothing new.  The Fed Funds rate was left unchanged; and the general themes of slow economic growth and modest inflation were re-emphasized with some ever so slight nuances.  Most important, we know that QE2 will be pursued to its stated conclusion and after that, there is little likelihood of any immediate reduction of the massive reserves currently on the banking system’s balance sheet.

Both factors appear to have to have instilled a ‘what me worry?’ syndrome among investors, leading them to disregard the risks of my biggest fear--which is inflation rising to levels beyond our forecast.  An irresponsibly expansive monetary policy?  It simply provides the almost cost free liquidity that is being used to buy more stocks.  Rising commodity prices squeezing profit margins and slowing growth of consumer demand?  There is no evidence in headline inflation.  A political class that is either too stupid or so intent on defending its job and fat life style that it pursues appallingly destructive fiscal/regulatory policies?  Just ignore it.  Soaring gold and silver prices?  Buy more.

Risks associated with international developments were in the background this week:
 
(1)    the Japanese situation continues to stabilize and no one seems to care that the Japanese central bank is exacerbating a Fed generated global liquidity problem through huge injections of its own. 

(2)    disruptions to future oil supplies and prices remain a threat.  The Middle East retains the potential of an explosion at any moment in multiple locations.  Violence is escalating in Syria.  The PLO and Hamas are making nice--who knows where that goes?

(3)    the EU was quiet this week but its sovereign debt problem isn’t going away.

Bottom line:  the economy is recovering at a below average secular pace accompanied by an increasing rate of inflation.  The risks of the latter seem to be growing; but investor attention is on the positive liquidity aspects of an overly easy monetary policy and the hope that foreign earnings can keep US corporate profitability rising faster than the US economy.  The latter argument is very similar to the ‘decoupling’ thesis back in 2007-2008 and that didn’t end well.  However, nothing is this week’s data or other economic/political developments suggest a reason to alter either of our Models.

This week’s data:

(1)    housing: weekly mortgage applications fell while purchase applications plunged; however, March new home sales were quite strong; on the other hand, the February Case Shiller home price index fell, again,
 
(2)    consumer: weekly retail sales were very positive; March personal income and spending were both better than expected; weekly jobless claims rose more than estimates; finally, the two measures of consumer confidence [the Conference Board and the University of Michigan] came in as anticipated,

(3)    industry: the March durable goods orders were in line with forecasts as was the April Chicago purchasing managers’ index,
 
(4)    macroeconomic: first quarter GDP rose much less than the fourth quarter 2010 number but was as expected.
   
     The Economic Risks:

(1)    the economy is weaker than expected.

(2) Fed policy (reading the data correctly). 

 (3) a disruption in global oil supplies (It is not the price of oil but its availability that will cause severe economic dislocation.).

(4) protectionism (Free trade is a major positive for world and US economic growth.).

(5) fiscal profligacy (Government spending as a percent of GDP is too high and the looming explosion in entitlement expenditures will make it worse.  There is no good solution save spending discipline.).
       
(6) a rising tax and regulatory burden (Government has never proven that it could solve economic problems efficiently or satisfactorily.)
   
Politics

The domestic political environment is a neutral but could be improving for Your Money while the international political environment remains a negative.

The Market-Disciplined Investing
    
  Technical

The Averages (DJIA 12810, S&P 1365) finished the week well within their intermediate term up trend (12017-15435, 1263-1692).  Today, the S&P confirmed its challenge of the upper boundary of its short term trading range and re-set to an up trend.  As I noted this morning, that resolves a number of disparities--both the indices and the trends are now back in sync and have successfully completed an inverse head and shoulders, historically a very positive indicator of future price action. 

The boundaries of the new short term up trends are 12280-12935, 1308-1375.  One additional price level to which to pay attention is circa 13250, 1450.  This represents the rough measure of upside potential resulting from the successful completion of the recent inverse head and shoulders.  It also happens to coincide with another visible resistance zone of 13102, 1437.  Finally, if I were to consider putting money back to work, note that the Averages close today (12810, 1365) was very close to the upper boundary of their newly re-set short term up trends (12953, 1375)--so even if I  decide to spend some cash, I want to await a short term correction for a better entry point.
 
All this said, (1) I am still unable to reconcile valuations as calculated by our Model with current prices; and I continue to try, (2) our Sell Discipline remains as important as ever.

A look at the statistics related to ‘sell in May and go way’ (medium):
http://www.investmentpostcards.com/2011/04/29/sell-in-may-and-go-away-fact-or-fallacy-4/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+wordpress%2FVYxj+%28Investment+Postcards+from+Cape+Town%29

GLD was up again this week, remaining well within its intermediate term and short term up trends. 

Bottom line:

(1) the DJIA and S&P are in an intermediate term up trend (12017-15435 and a short term up trend (12280-12935, 1308-1375),

(2)    long term, the Averages are in a very long term [78 years] up trend defined by the 4187-14789, 644-2000 and a shorter but still long term [13 years] trading range defined by 7148-14198, 766-1575. 

   Fundamental-A Dividend Growth Investment Strategy

The DJIA (12810) finished this week about 24.1% above Fair Value (10322) while the S&P closed (1365) around 6.9% overvalued (1276). 

Stocks are becoming increasingly overvalued, at least as calculated by our Valuation Model.  As I keep noting, try as I may, I have yet to find a reason sufficient to warrant an up grade in the assumptions to either of our Models. 

(1)    certainly, the US economic data gives no hint of improving over our forecast,

(2)    fiscal policy isn’t apt to change for the better any time soon,

(3)    the Ber-nanke told us explicitly this week that monetary policy was going to remain very accommodative.  This, of course, is one of two sources of our clear disagreement with the Market.  My biggest fear is that our forecast is underestimating future inflation while consensus seems to believe that all that money is just for buying stocks [and by implication pushing them higher in price].  Nothing is going to resolve this divergence in opinion except the facts as they occur.

(4)    the other area of disagreement is the interpretation of the better than expected first quarter profits.  As I argue above, I am not convinced that the earnings growth rate implied by these recent reports is sustainable or properly reflective of the true value of shareholders’  ownership; and therefore, my error may be more one of timing [of a profit growth slowdown] versus missing a change in underlying fundamentals.  To be sure, I could be wrong on this point; but I need at least another quarter’s data before crying ‘uncle’.

Of course, this discussion is all fine and good; but the issue is, what do I do now?  The answer is that I have compiled a list of US, foreign and gold ETF’s that our Portfolios can Buy as a trade with very tight stops with the objective of taking cash from roughly 20% to 10%.  However, as I noted above, both index is nearing the upper boundary of its short term up trend, so I am going to wait for a correction before taking the plunge.

This week, our Portfolios took no action.

           Bottom line:

(1)      our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,
 
(2)    we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk.  An investment in gold is an inflation hedge and holdings in other countries provide Angel a hedge against a weak dollar and Beer exposure to better growth opportunities,

(3)    defense is still important.

                                                                             DJIA                    S&P

Current 2011 Year End Fair Value*               10760                  1330
Fair Value as of 4/30/11                                10322                    1276
Close this week                                               12810                  1375

Over Valuation vs. 4/30 Close
      5% overvalued                                         10838                     1339
    10% overvalued                                         11354                      1403 
    15% overvalued                                         11870                     1467
    20% overvalued                                         12386                    1531
    25% overvalued                                         12902                    1595

Under Valuation vs. 4/30 Close
    5% undervalued                                        9805                     1212
  10%undervalued                                           9289                      1148
    15%undervalued                                         8773                    1084

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years with somewhat higher inflation. 

The Portfolios and Buy Lists are up to date.


Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 40 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns,  managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.









Posted 04-29-2011 7:07 PM by Steve Cook